When people believed the 14-monthslong U.S.–China trade negotiations were finally drawing to a satisfactory close, Beijing made a surprising move to backtrack on all major agreements, to the great annoyance of Washington. In addition to the ensuing tariff increase, the overall U.S.–China bilateral relationship is also heading toward a danger zone.
China Rescued by US ‘Saviors’ in 2018
To truly understand the dynamics between one country’s currency depreciation and another country’s tariff increase, advanced statistical models need to be established to analyze corresponding data, which requires expertise and a lot of time investment. This article focuses on the second measure mentioned.Shortly after the start of the U.S.–China trade war, MSCI and FTSE Russell included China’s A-Shares in their stock indices in June 2018. This was followed by the Bloomberg Barclays announcement to include China’s bonds and policy bank securities in its widely tracked fixed income Global Aggregate Index. These decisions led to an influx of foreign funds into China, which relieved its capital markets from a crisis.
As I wrote in a March 25 tweet, “China stumbled upon a couple of saviors when its economic prospects looked quite grim in 2018. Savior No. 1 was the Democratic Party seeking every opportunity to impeach President Trump and win back the House of Representatives. Savior No. 2 was the top global index makers: MSCI and FTSE Russell officially included A-Share into their indices.”
On April 1, Bloomberg Barclays made its announcement as planned. The included bonds are China’s government and policy bank securities. That was a great news for China’s capital markets, and one source of confidence that emboldened Chinese leader Xi Jinping to renege on trade negotiation agreements. Bloomberg’s endorsement has made the yuan currency the fourth-largest currency component following the dollar, euro, and yen.
‘Hand of God’ in Global Capital Markets
Regarding the power wielded by financial rating agencies (index makers included), consulting firm McKinsey remarked in its 1996 book, “Market Unbound: Unleashing Global Capitalism,” that the global capital markets hold strong power over sovereign countries, while sovereign countries’ control over the capital markets are weakening. And those who have the rights to affect pricing in the capital markets will control the flow of capital, and thus control the currency and financial policies of sovereign countries, as well as their fates.Shortly after the book was published, an economic crisis emerged in Asia in 1997. President Bill Clinton’s adviser James Carville once quipped, “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody. Of course, even better if I can freely decide bond prices, like a supervisor at a credit rating agency.”
Years later, Thomas L. Friedman described credit rating companies in his book “The World is Flat” as one of two superpowers in today’s society: the United States of America, and Moody’s. The former can destroy you with bombs, Friedman said, while the latter does so by lowering your credit ratings. And sometimes no one knows which of the two is more deadly, Friedman remarked in the book.
That’s why rating changes from these international credit rating firms can sway Beijing’s mood. A higher rating gives the regime a new sword, while a lower rating puts Beijing on pins and needles. For example, when the three top companies—S&P Global, Moody’s Investors Service, and Fitch Ratings—lowered China’s credit ratings in 2017, Beijing had to tolerate it, as it could not afford offending multiple top agencies. On May 7, Morgan Stanley downgraded its equity rating of China’s four largest banks to “equal weight” from “overweight.” Two of the four banks saw immediate stock price drops after the announcement, which received a lot of criticism from Beijing.
S&P and Moody’s, the two largest rating firms, control the world’s credit ratings while MSCI and Bloomberg hold the key to the financial markets. Backed by these powerful organizations, the Chinese capital markets are performing well: In 2018, the net influx of foreign capital reached about $100 billion, accounting for 80 percent of all inflows entering emerging markets. In the first quarter of 2019, more than $18.6 billion entered Chinese stock markets via the Shanghai-Hong Kong Stock Connect and the Shenzhen-Hong Kong flow, about triple that of 2018.
On April 10, the Bank of China issued $3.8 billion worth of multi-currency bonds to raise low-cost funding to support its “One Belt, One Road” initiative. The bonds were issued in five currencies, including the dollar, the euro, the yuan, the Hong Kong dollar, and the Macau pataca. European investors accounted for a record 83 percent of the investors for the euro-denominated bonds, including a 45 percent from the large eurozone economies of Italy, Germany, and France.
How Powerful Is Trump’s Punch?
China has played its “market-for-technology” game for almost three decades with major tactics being “begging, borrowing, and stealing.” Clinton needed the Chinese market to push forward globalization; President George W. Bush needed China’s collaboration in anti-terrorism campaigns post-9/11; President Barack Obama gave China plenty of opportunities to steal intellectual properties. Now, it’s finally time to settle it all. But the turn is so sharp that all the free-riders (including the European countries) are complaining about Trump.If Trump can truly pressure MSCI and Bloomberg to kick Chinese securities out of their global indices, it will deal a heavy blow for China. Weakening the enemy’s ability to attract capital is the outpost battle prior to a full-fledged financial war. On the other hand, the rare earth strategy that Chinese propaganda mouthpiece has been boasting is most likely simply bluffing. The U.S. Department of Defense admitted that rare earth is a necessity of the country’s many weapon systems, including the manufacturing of laser, radar, sonar, night vision, missile, jet engine, and alloys for armored fighting vehicles. However, America’s reliance on China’s rare earth has become very low.
“Chinese customs data show that the United States bought only 3.8 percent of China’s exports of rare-earth metals last year,” a New York Times article stated. In addition, China has become the largest rare earth ores importer since 2018, with the United States as one of its largest suppliers.
But Trump’s efforts may be met with resistance. While the president is the country’s commander in chief, he can only gently pressure the U.S. credit rating companies, and can’t force them to make any “professional” conclusions unless China has officially announced an enemy.
This reminds me of something that has already played out before. S&P announced a downgrade of the United States’ sovereign credit rating from “AAA” to “AA-plus” on Aug. 5, 2011, and warned of additional downgrades in the future. The company also cut the long-term U.S. credit rating to “AA-minus.” This was the first time that the U.S. federal government was given a rating below “AAA” (outstanding). Moody’s, though, didn’t change its rating, although it warned of a possible downgrade.
Currently, both the United States and China are still just threatening to escalate a “war,” but at different levels. On the U.S. side, it’s done by Trump’s tweets or through senior officials; on China’s side, it’s been voiced by the party mouthpieces such as the People’s Daily, Xinhua, and persons of interest like Ren Zhengfei, while the top leader and senior regime officials are mysteriously silent.
The outside world can only guess at what Zhongnanhai is really thinking, comparable to the art of “Kremlinology” of the Soviet Union during the Cold War. Xi’s visit to a rare earth mine was interpreted as his signal to retaliate with “rare earths” ban. Xi’s calls for “girdling up for a new Long March” after laying a floral basket at a monument for the Red Army’s Long March was thought to be a statement of determination to hold his ground in the trade war. In China, the political system ensures that all commercial enterprises obey the Chinese Communist Party, and that no individual company would dare to help the enemy during a trade war headed by the party leader himself.
But in my opinion, Xi believes he has enough information to confidently continue his “dawdling strategy” (I will elaborate in a subsequent article) in hopes that Trump will lose the next election and that the U.S.–China relationship will go back to what it was in when the Democrats held the White House.
Trump, seeing such strategy clearly, can now only say that he isn’t in a hurry to close the deal. Until there is additional clarity on the 2020 U.S. elections the negotiations, if they continue at all, would result in nothing.
Until then, both parties will slowly but surely inch toward the danger zone.
